With inflation soaring in recent months, equity market investors have used old street wisdom to find hedges or protection for commodities, REITs or real estate funds, as well as equity and equity funds. While these asset classes offer protection against energy inflation, they do not offer protection against core inflation, according to a new research paper by experts at Wharton and the University of Hong Kong entitled “Getting to the Core: Inflation Risks Within and Across Asset Classes”. . “
“The most important lesson from our research is that you have to look at what is known as core inflation separately, excluding food and energy,” said Wharton finance professor Nikolai Roussanov, who co-authored the paper with Xiang Fang and Yang Liu’s Assistant Professor of Finance at the university of Hong Kong. “Much discussion in the popular press about different asset classes in relation to inflation fails to make this distinction.”
Core inflation tracks the prices of goods and services, including housing, home furnishings and establishments, clothing, transportation, health care, and recreation. The indices for core inflation, together with those for food and energy inflation, form the consumer price index or headline inflation. The consumer price index for urban consumers rose 5.4% (before seasonal adjustment) in June 2021, which is the largest 12-month increase in 13 years, according to the latest report from the Department of Labor. In it, core inflation rose 4.5%, the largest increase since November 1991, and energy inflation rose 24.5%; the food index rose by 2.4%.
“[Conventional wisdom that] Commodity futures, for example, are a good protection against inflation because commodity prices are not necessarily going to rise, ”said Roussanov. While commodity futures offer a hedge against energy inflation, “energy isn’t always the major component of inflation,” he added. “It’s just that inflation has been subdued overall for the past 20 years and energy really stood out as its most volatile part. Many inflation movements have been masked by high energy prices, oil in particular being the strongest.
“Many inflation movements have been masked by high energy prices, oil in particular is the strongest.” –Nikolai Roussanov
Most important findings
“We argue that dividing inflation into core and non-core components (with a particular focus on energy) is important as it sheds new light on the nature of inflation risk,” the paper said. “First, core and energy inflation have vastly different statistical and economic characteristics. Second, the inflation-hedging properties of conventional “real assets” like stocks, currencies, and commodity futures are largely limited to energy inflation, while providing almost no protection against core inflation risk. Thirdly, core inflation bears a clearly negative risk price, while the risk price associated with energy inflation cannot be distinguished from zero in most cases. “
In their study, the authors examined the returns in seven major asset classes between 1963 and 2019: US stocks, treasury notes / bonds, agency bonds, corporate bonds, currencies, commodity futures and REITs. The data had different starting points between 1963 (for stocks and government bonds) and 1983 (for energy).
These were their most important insights:
- The conventional wisdom that stocks, currencies, and commodity futures are real assets is incomplete: they only hedge against energy inflation. A long position in any of these seven asset classes cannot hedge against core inflation.
- The cost of inflation hedging – or the price of those inflation risks – of headline and energy inflation are indistinguishable from zero. However, core inflation carries a significant negative risk price. In other words, hedging your portfolio against core inflation is potentially costly due to lost returns.
- Among the commodities, precious metals, especially gold, are the best accepted assets for maintaining value. Gold and platinum have positive core inflation betas (volatility and therefore risk) that are statistically indistinguishable from zero, and they protect themselves strongly against energy inflation. These precious metal futures have relatively low yields and high volatility, so their ability to protect against core inflation risk is far from assured.
Inflation dynamics also changed after the pandemic. “After Covid, core inflation or commodity prices have risen in large parts of the economy, not just in terms of energy costs,” said Roussanov. Higher commodity prices are driving costs up elsewhere in the economy as well, he added. “These two components of inflation – core inflation and energy inflation – often do not go together. But if they do and both rise, in a certain way they will reinforce each other. “
Aside from commodities, most other asset classes “do not offer good protection” against core inflation, he added. Markets across the board are revising assumptions about assets that were previously thought to be an adequate hedge against inflation – cryptocurrencies like bitcoin, gold and other precious metals, as well as inflation-protected treasury securities or TIPS, whose values are adjusted to reflect changes in the consumer price index. Bitcoin prices, for example, have steadily fallen since their peak in March 2021.
“Now we could actually see both stocks and bonds going in the same direction, which of course increases the risk to an investor’s portfolio.” –Nikolai Roussanov
The relationship between stocks and bonds will also change, according to Roussanov. “In the last 20 years [a combination of stocks and bonds] has proven to be a very robust portfolio because stocks outperform when times are good and bonds are more or less safe, ”he said. “And when times are bad, the Fed cuts rates to make bond yields fall, which is good for bond prices. So even though stocks are falling, say in the Great Recession or even in March 2020 with Covid, government bond prices have actually skyrocketed due to the Fed cuts that have compensated investors with such portfolios to some extent. “
“We could see a break in this negative relationship between bonds and stocks,” Roussanov continued. “When inflation picks up, it’s bad for stocks and bad for bonds at the same time.” This new equation played out around February 2021, “when there was this heightened inflation concern, bond yields rose, and stock prices began to stutter too.” he noticed. “This is the paradigm we should possibly get used to. Now we could actually see both stocks and bonds going in the same direction, which of course increases the risk to an investor’s portfolio. “
Options for Investors
What reliable options are there for investors to hedge against inflation in the current scenario? “Sit tight. There will be very few things in that basket as far as we’ve been able to find out so far, ”said Roussanov. “Some of the precious metals like gold and platinum seem to have some inflation hedge potential. But they are not very reliable or very strong in the sense that they are quite volatile. ”He noted that while Bitcoin or other cryptocurrencies are viewed as an option by some market watchers, he and his co-authors do not recommend them because their relative origins do not provide sufficient historical data to draw conclusions. he also pointed to their recent price volatility as negative.
However, TIPS are always an option for investors, says Roussanov: “TIPS offer a reliable one [option] for those who want to protect their portfolios against inflation; TIPS are the safe haven. They are not particularly attractive – they have negative returns precisely because inflation expectations have risen. “
“If [the current trend] With inflation being temporary and relatively mild, a balanced portfolio with a range of stocks and inflation-linked bonds should do reasonably well in the near to medium term. ” –Nikolai Roussanov
Demand for TIPS has grown sharply, with $ 36.3 billion in new investments made in the first half of 2021, another Wall Street Journal the report said, citing data from Morningstar. After adjusting for inflation, TIPS rates have been below 1% for most of the last decade and have turned negative in recent years, with the tradeoff being inflation protection for the principal.
Of course, persistently high inflation isn’t necessarily set in stone, and much depends on how the Fed reacts to recent spikes. Federal Reserve Chairman Jerome Powell said in a House testimony last week that recent inflation has been uncomfortably above the levels the central bank is aiming for Wall Street Journal reported. In June, Powell indicated that he expected inflationary pressures to be temporary as many goods and services were exposed to one-off price increases after the economy reopened, such as airfare and hotel prices, and new and used cars.
“We’ll have to wait and see if the Fed is right about this spike in inflation being really temporary, and we’ll go back to where we were a few years ago,” said Roussanov. “It is certainly not a given that inflation will continue to rise. I wouldn’t expect anywhere near what people are worried about – the 1970s nightmare scenario of high inflation. I don’t see the prerequisites for this. “
This outlook offers hope for investors. “If [the current trend] With inflation being temporary and relatively mild, a balanced portfolio with a balanced combination of stocks and inflation-linked bonds should do reasonably well in the near to medium term, ”said Roussanov.